Money Management Risk Concepts

Risk is defined in many ways in various sources. It can refer to the variability of returns, the amount of loss per trade, beta, maximum loss per trade, price volatility, and so on. Our focus is on risk as a loss of capital. This will be our definition of risk, and we shall use the word “risk” with exactly this meaning throughout this chapter.

A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk that an investor is willing to take, the greater the potential return. The reason for this is that investors need to be compensated for taking additional risk.

Reward to Risk

The objective in all investment is to achieve a high reward-to-risk ratio. Return on investment, or ROI, is the standard way of measuring reward. ROI is calculated as net profit divided by the initial capital at the beginning of the measured period. The standard method used for analysing any trading portfolio and system for reward and risk is to calculate the ratio of ROI to the maximum possible loss.

Because of the risk-return trade-off, you must be aware of your personal risk tolerance when choosing investments for your portfolio. Taking some risk is the price of achieving returns; therefore, if you want to make money, you can’t eliminate risk entirely. The goal instead is to find an appropriate balance – one that generates profit but still allows you to sleep at night.

What can be considered a suitable risk/reward ratio in Forex trading? A ratio of 1:3 or even 1:5 is achievable if you manage to enter a newly forming trend in time. With sufficient experience, you should be able to spot the tops and bottoms of the trends, regardless of the time frame on which you are trading. Even if you enter in the middle of the action, the trend should still be able to deliver another substantial move, allowing you to make a profit three to five times greater than your stop loss. However, there are a few problems.

1. Very often, markets don’t form a trend at all; instead, they trade sideways

2. Some trends are not strong enough to ensure a 1:3 or 1:5 risk-to-reward ratio if you enter them late, during their middle phase

3. Hesitation about whether to enter a trend can cause you to miss it and enter too late, when the trend is ending and the price reversal triggers your stop loss.

A possible solution is to move the protective stop. It is advisable not to let your stop loss remain at its initial position; rather, move it as price action develops in your favour. Of course, each trader has to evaluate for himself or herself how much to raise the stop.

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Percentage Risk Method

The percentage-risk method involves risking the same fraction of your account balance, expressed as a percentage, on each trade.

The percentage-risk money-management method stipulates that you should risk a constant percentage of your account balance on every trade. To calculate this for each position you wish to enter, you need to determine both the percentage risk and the trade size. Armed with these two figures, you will be able to estimate where to place your protective stop.

As a trader, the primary risk is known as drawdown. Drawdown is the amount of money you have lost in your account on a single transaction.

If you have a $1,000 account and lose $50 on a single trade, your drawdown is $50 divided by $1,000, which equals 5%.

Example

The example below shows the difference between risking a small percentage of your capital and risking a higher percentage. Good money management requires you, as a trader, not to risk more than 2% of your total Forex account equity.

Normal risks

Beyond establishing where and what kind of stops to use to protect capital, the most important aspect of money management is determining the position size for each trade.

An overly large position can incur unwarranted risk in the event of failure, including complete loss of capital, whereas too small a position can reduce profit potential below the risk-free rate. Position size is directly related to capital risk (the amount of money that can be lost), and it is the aspect of money management that most traders and investors overlook.

Position size

It refers to the amount of capital committed to an investment that incurs a specific risk. It is usually based on the difference between the entry price and the exit price multiplied by the number of shares or contracts.

Example: Assume we have $500 in capital. Let us use a system that will buy an instrument at $50 and place a stop loss at $45. The $5 difference in price is the capital risk we are taking. The entire position is not at risk because it will be liquidated at the stop. If we do not use stops, we have no idea what risk we are taking. This is one flaw of fundamental analysis, which has no means to indicate when to exit a position.

Leverage

Leverage – the borrowing of capital to increase the potential for gains – also increases risk. Risk is proportional to leverage. Leverage generally increases the volatility of the portfolio or system and thus magnifies all the dangers arising from increased volatility, such as larger drawdowns and a greater potential for complete ruin.

Pyramiding

Risk can drastically increase because of the greater amount of capital locked into the position.

Unusual Risks

Trading and investing are largely psychological. The movement of investment vehicles is driven by both rational and irrational decisions made by buyers and sellers. Taking advantage of this price movement is an emotional exercise for the trader. The market participant must be careful not to be swept up in the emotion of the crowd; in many cases he or she should act against the crowd, which runs counter to human nature. External factors can also affect a trader’s psychological well-being, such as lack of sleep, family conflict, illness or a run of poor results. Unfortunately, once a lack of success begins, a loss of confidence often follows. The purpose of designing a system is to minimise these emotional factors and to help traders get back on track, thereby diminishing their negative effects.

Diversifiable risk

Diversification is the common-sense approach of “not putting all the eggs in one basket”. If different systems are used for diversification, they should not act in concert; otherwise, they are essentially the same system.

Risk can be both correlated and uncorrelated. Correlated risk might be, for example, the risk that the Federal Reserve tightens the money supply, which would have a widespread impact on security values and affect almost any instrument. Correlated risk cannot be reduced by diversification. Uncorrelated risk, however, can be diminished by diversifying one’s portfolio and thereby reducing the effect of individual issues.

Trade Frequency

Ten losing trades in different markets are the same as ten consecutive losses in one market – the drawdown is identical. Thus, diversification can bring problems as well as reduce risk. A high frequency of trading across different markets will increase the risk of a series of losses that spans multiple markets.

Temporal

Risk increases with time. The longer a position is held, the riskier it becomes, which is why long-term interest rates are usually higher than short-term rates. In the markets, however, reward does not necessarily increase with time. Therefore, to reduce risk, a position should not be held beyond the point at which the reward ends – after that, only risk remains.